* Euro cuts gains as Spanish borrowing costs rise
* Italy sells three-year debt at 6-mth high of 5.3 pct
* Investors wary ahead of Greek election on Sunday
By Anirban Nag
LONDON, June 14 (Reuters) - The euro pared gains against the dollar on Thursday as Spanish and Italian bond yields surged, highlighting the risk of euro zone contagion ahead of Sunday's elections in Greece that could lead to the country being pushed out of the common currency.
The euro's outlook may stay bearish after benchmark 10-year Spanish government bond yields hitting 7 percent on Thursday - a level where fellow euro zone members such as Greece and Ireland had to seek international bailouts as it is seen as too expensive in the long term.
The aid deal put together for Spanish banks at the weekend has signally failed to calm the markets, with Italian three-year borrowing costs spiking to 5.30 percent at an auction on Thursday.
The common currency fell to a session low $1.2542 on trading platform EBS, turning lower on the day and off the day's high of $1.25894. It was last trading at $1.2565 with large option expiries cited at $1.2500 which could curtail losses for the time being.
"Spanish yields are creeping up, which clearly indicates that the bank bailout deal will not change anything and they are dragging Italian yields higher," said Stuart Frost, head of Absolute Returns and Currency at fund manager RWC Partners.
"For the euro/dollar, all this means it is on a slippery slope down."
Earlier, the common currency took Moody's downgrade of Spanish government debt to one notch above junk status in its stride.
Many analysts said the euro was likely to trade between $1.24 and $1.27 ahead of Sunday's Greek vote, with investors either reluctant to initiate fresh bearish bets or squaring positions given uncertainty over the election outcome.
Speculators have added to very large bearish bets against the euro in the past few weeks, leaving scope to the euro to stage a short-covering rally if parties supporting austerity and reforms in Greece win at the weekend.
Right now, it is too close to call and a victory for the far-left SYRIZA, which opposes the austerity measures on which Greece's bailout deals are based, would intensify fears of a potential euro zone break-up, and likely push the currency towards recent two-year lows around $1.2280.
A sharp rise in yields on German Bunds, viewed as the euro zone's safest asset, has also raised concerns that the cost of the debt crisis is growing for Germany, the bloc's paymaster. A further rise in German yields would weigh further on the euro, traders said.
SNB REITERATES FRANC CAP
The Swiss franc rose against the euro after the SNB said it was prepared to buy unlimited amounts to defend the 1.20 level. The euro fell to 1.2008 francs on trading platform EBS, from around 1.20196 before the announcement.
Traders said the SNB has been buying lots of euros in recent weeks, stepping up its defence of the cap ahead of the Greek election, which could fuel demand for the safe-haven franc. SNB President Thomas Jordan hinted that capital controls could be introduced if the situation in the euro zone deteriorates and puts more upward pressure on the franc.
"Clearly the SNB is trying to downplay the franc's attractiveness and buy more time. We expect further pressure on the euro/Swiss franc 'floor' in the coming days, especially considering the Greek elections," said Peter Rosenstreich, chief FX analyst at Swissquote Bank, in a note.
Against the yen, the euro eased 0.1 percent to 99.60 , off a session high of 100 yen, with Japanese exporters' bids lined up above that level. The dollar fetched 79.26 yen, off Monday's high of 79.92 yen with expectations of more easing by the Federal Reserve weighing on the greenback.
The New Zealand dollar was up 0.5 percent on the day at US$0.7778, paring gains from Wednesday, when it hit a one-month high of $0.7808.
The kiwi eased after the Reserve Bank of New Zealand said a weak economy and an uncertain global outlook meant rates need to stay at record lows. As expected, the RBNZ kept rates unchanged at 2.5 percent for a 10th straight meeting.
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